Traders, Are Commodity ETFs Fueling the Energy Spike?

In today's Guest Blog spot, I decided to contact Chuck E. Cash from Forex-Trading-School.com. I wanted to get his thoughts and insight on what he thought about the current commodity markets, with Crude and Gasoline as the specific targets. Take a look below and enjoy!

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It's hard not to notice the rally cries coming out of the political parties lately. Each side has their "solution" for the energy problem. The left wants windfall profit taxes and investigations. The right wants a tax holiday and more drilling.

Lately I've been wondering, are the spat of energy ETFs partly to blame?

Conceptually, the energy ETFs should create a more liquid (and thus more perfect) market. But I am starting to have my doubts.

For those unfamiliar with these commodity ETFs, let me explain who they are and how they work.

The first US traded energy ETF, USO, was introduced just 2 years in April 2006. This was the first in a series of unique ETFs whose assets were held in futures and options contracts. Specifically, they seek to track the spot price of West Texas Intermediate (WTI) light, sweet crude oil. These funds also invest in futures contracts for other types of crude oil, heating oil, gasoline, natural gas and other petroleum based-fuels.

This is in sharp contrast to previous commodity ETFs such as GLD, which is backed by some 600+ tonnes of the gold.

Since USO was introduced, other petroleum tracking ETFs have followed.
The aptly named OIL opened August 15 2006.
UCR opened November 29, 2006.
In January 2007 Deutsche Bank introduced DBO and DBE.
And the newest member, UGA which just started trading Feb 26 2008, tracks gasoline futures.

So what's wrong with all these ETFs? Why would they drive up energy prices?

IMO, the commodity ETFs have contributed in 2 key ways.
1. They have allowed casual investors to participate

Futures trading is frequently described as both risky and sophisticated. No doubt, this is because futures are traded on margin, which creates huge profit and loss swings in a short period of time.

By packaging the futures into an ETF though, many participants now see it as a type of stock and behave accordingly. They are willing to buy and hold. They are able to sit through a $14 down turn believing their asset will rebound.

2. They create a new entity, a tracker.

For close to 2 centuries futures markets worked with three types of participants - producers, users, and speculators. These new ETFs have added a 4th entity, a tracker whose sole role is to mimic price movements. Now the traditional players must compete with this new tracker for shares of the same asset. Demand for the contracts has grown while the supply of contracts has not. As we all know, when demand outpaces supply, prices go up.

Don't get me wrong, I'm a capitalist pig no doubt. And I don't think closing these ETFs is a panacea. But I do believe they are exacerbating the spike.

So traders I ask, what do you think?
Are these ETFs helping to create a perfect market that reflects a fear of peak oil?
Or, are they creating a new type of speculation that is contributing to the spike in energy prices?

Chuck E. Cash from Forex-Trading-School.com

14 thoughts on “Traders, Are Commodity ETFs Fueling the Energy Spike?

  1. "I repeatedly hear of ETF and Commodity buyers. Are there any sellers and what role do they play?
    (Bob Anglemier)

    There are always sellers as well as buyers. It just means that when the market is rising, there are far more byuers.

    What do you think would happen if crude oil prices started to decline towards say $100 then $80, and influential people said oil is going to be cheap?

    For now most people think crude oil is going one way only, hence the $145 price per barrel and rising!

  2. I repeatedly hear of ETF and Commodity buyers. Are there any sellers and what role do they play?
    Last year here in Cookeville some of my farmer friends sold hay at rediculous prices and both buyer and seller were happy as a 4-wheeler in mud.

  3. If your logic is correct then the opposite scenario woud have to apply. That is, will the oil ETF's create a deeper spike down if prices fall?

    If you will recall the USO ETF was in deteriorating condition from the outset because it has monthly expenses trading futures, and they cannot make money in a market moving sideways. Even now the ETF is not at par with oil because of the monthly operating cost.

  4. Comment:
    The reality about the fact of in how extend can the volume of USO or similar markets affect the overall price of securities like OIL or commodities generally, i think it,s not the volume that affect prices these days, but the psychological effect of it. remember we are facing a type trading instrument that can be leveraged to huge amounts of trading.
    Also, The rumors that almost control everything,s price today are just talking about new opportunities in OIL trading for portfolio managers all around the globe. That,s why i think this kind of markets will dominate the overall pricing process very soon.

    Be well!

    S.A Ghafari
    FX Analyst

  5. Correction:
    Is there really enough volume in USO (stock + options) when compaired to the enourmous crude oil futures market to affect price? I haven’t done any calculations, but I do trade USO options. Open interest in these don’t seem anywhere near large enough to conterbalance Crude futures. I trade a small futures (approx $35k) acct. and a slightly larger stock/option acct. I try to keep my risk per trade to approx. 3%, or $1000 (I swing or short term position trade the futures). This is impossible with even the mini-crude. So I personally am glad to be able to leverage the price on a smaller scale with USO options.
    Sorry.

  6. The ETFs beside being a marginally safer investment than a margin traded futures, has another hidden aspect in influencing Energy market future. The ETFs
    encourage classic type of commodity speculators and portfolio managers to take a bigger portion of commodities into their basket of safe but still profitable instruments. This will dominate the commodity markets and specially Oil and GOLD prices while history shows when the US equities going volatile and uncertain, the commodity market will hug concerned-mind monies first.

    Political and unwanted events like wars, explosions, terrorism threats, stopped refineries , supply sites, historically and presently act as the "major psychological effect" on commodity prices while in the matter of fact these type of elements is not a realistic pretext at all to see a 140$ a barrel of oil. I think these kind of threats are actually effective tools between speculators who always trying to echo, " Hey..!
    Very Bad Days for OIL..! Is n,t it?? We gotta hold the contracts..! That,s gonna be 200$ a barrel day very soon..!!.

    The OPEC organization is just like above mentioned paragraph. The fact about supply-Demand story is just like a joke. The supply is just fine and i never heard of any lack by any OIL expert from OIL producers countries. The fact is just written on the Big Brothers of speculators in NY and LONDON.
    Anyway, I ain,t Sell my OIL ETFs because it just don,t make sense to see a cheap OIL and It just planned to be 200$ very soon, as every smart trader knows, " Don,t Ever Trade Opposite to Major Trend!".

    Thanks for your time.

    S.A Ghafari
    FX Analyst

  7. Is there a disconnect between commodity price and the futures/options (which is held by USO,etc)? If 100 dollar worth of crude has futures worth 10000 dollars vs 50 dollar worh of futures what is the implication? If it is 10000 dollars worth - it is akin to what happened in housing market. Just wait for oil demand to go down 5%, you get 30% correction.

  8. Long-term investors do not increase "stability," because their actions run counter to the normal supply-and-demand interaction with prices.

    Normally, when the price Increases, the quantity demanded Decreases. (and vice-versa) This tends to limit price changes, and maintain price stability.

    In this case, however, long-term investors are causing exactly the opposite effect. As prices increase, the quantity demanded is increasing. The result is that price increases exert a positive feedback on themselves. Increasing prices increase demand, causing further increases in prices.

    Banning long-term investors would greatly reduce this self-perpetuating increase in prices.

  9. Why would you want to ban long term investors such as pension funds? I would have thought that long term investors would bring a degree of stability and liquidity to the markets and act as a buffer against the volatile swings we have seen in recent times. Unless of course that is the fear, that is without the volatility we see now some people would not make the same mega profits.

    1. You seem to be unaware that there was ever any information on this page other than what you already had in your head upon waking today.

  10. For starters, ban all the long-only investors such as pension funds and modifying the etf's might not be a bad idea either.

  11. Commodity ETF's are likely to become more popular because they provide exposure to commodity markets without the leveraged risk of a futures contract entered on margin. In the medium to long term we are likely to see more institutional investors, including pension funds, allocate more funds to commodities as an asset class. Retail investors are also likely to see ETF's as a relatively less risky way of diversifying their porfolios compared to using futures or options.

  12. I do think they would create an imbalance, but if an inverse fund is matched with it then all bets are off.

  13. You bet they are. Add in institutional investors, hedge funds, and investment banks to the mix and you can only wonder what the impact is. Even traditional speculators want them out and that's saying something.

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